Financial Risk Management Articles

Critics of Glass-Steagall had also warned that federal deposit insurance would encourage excessive risk-taking, what economists call “moral hazard.” According to this argument, because depositors would no longer have to worry about the soundness of their banks and might well be attracted by the higher interest rates offered by riskier institutions, funds would ultimately flow to weak banks—rather than strong—and losses could mount. Said one opponent in 1933, “A reputation for high character [in banking] would be cheapened and recklessness would be encouraged.”

Fortunately, the authors of Glass-Steagall (and the follow-on Banking Act of 1935) prepared for this threat, authorizing not only public deposit insurance but also meaningful bank regulation, designed to ensure the safety and soundness of insured banks. Regulation was necessary to deal with the moral hazard that critics warned about. The combination of insurance and regulation adopted as part of Glass-Steagall engendered a powerful dose of consumer protection, a remarkable reduction in systemic risk, and a notable increase in public confidence in the financial system. By all indications, this well designed risk-management policy strengthened the financial markets and helped prevent subsequent crises.

Calm Amidst the Storm: Bank Failures (Suspensions), 1864-2000

Sources: Historical Statistics of the United States: Colonial Times to 1970 (Washington, D.C.: Government Printing Office, 1975), Series X-741 (p. 1038); “Failures and Assistance Transactions, ” Table BF02, FDIC website (www2.fdic.gov/hsob/index.asp).

In retrospect, it appears that the New Dealers hit on a successful strategy: stringent regulation (combined with mandatory public insurance) for commercial banks, the biggest systemic threat at the time, and a lighter regulatory touch for most of the rest of the financial system. This approach helped ensure financial stability and financial innovation—the best of both worlds—for half a century. In fact, significant bank failures (in the form of the savings and loan crisis) did not reappear until after the start of bank deregulation in the early 1980s, when oversight was relaxed and the essential link between insurance and regulation was temporarily severed.